Deutsche Bank upgrades Sainsbury's on Argos margin potential

Deutsche Bank upgraded Sainsbury's to 'buy' from 'hold' due to the expected benefit to earnings from the pending Argos acquisition and the supermarket's reduced level of price promotions.

Deutsche said it believed investors were currently reluctant to factor-in the likely earnings accretion due to risks around the execution of the takeover.

Sainsbury’s said it expects the deal to be earnings-accretive in the first full year post completion and double digit accretive in the third full year post completion.

That was based on estimated EBITDA synergies of £120m, but they have since been increased to £160m.

The German bank forecasts in the long-term the synergies from lower Argos costs will generate 4.5p of additional earnings per share, adding 20% to consensus forecasts for the 2018/2019 financial year of 22.4p and 25% on its own forecast of 18.2p.

"Within the context of high fixed costs and slim margins, we think rents are one of the key challenges facing UK food retailers today. The ability to enhance asset turn, and the related cost savings which drive the earnings accretion, is a key attraction of this deal in our view," DB said.

Although Argos’ general merchandise and electricals offering is more cyclical than food, the lower cost base from the merger is felt likely to increase its profitability from its previously 1%-2% margin.

Reading data from Kantar that suggested Sainsbury’s give-away - the value of promotions over total sales - declined circa 2% in calendar 2015 vs 2014, while the market was broadly flat and Big 4 peers were flat or up, indicated Sainsbury’s has achieved the greatest reduction in the level of promotions of the Big Four grocers over the past 18 months.

Analysts think this can contribute to a better margin trend.

With Sainsbury’s shares trading at 13 times consensus 2016/17 earnings, the price "already reflects downside risk to near term earnings", analysts wrote, viewing the risk/reward skewed to the upside.

"In combination with a circa 3.5% dividend yield, we see 15% return potential," they added, setting a price target of 325p.